How does Magic Formula Investing Work?

Magic Formula Investing is a value investing strategy based on buying 20-30 quot;good, cheap companiesquot; defined as having the best available combined ranking in terms of earnings yield and a return on capital.

Background

A widely respected hedge-fund manager, Joel Greenblatt started as a value purist but was influenced by Warren Buffett's view about growth being part of the value equation. He founded Gotham Capital, a fund which apparently returned over 40% annualized from 1985 to 2005. By 1995, it had returned all money to its outside investors. He has authored two books, You Can Be A Stock Market Genius and New York Times bestsellier, "The Little Book That Beats the Market", and is also adjunct professor at Columbia University Business School. Greenblatt espouses MFI as a do-it-yourself version of the approach he has used while amassing his investment track record. With the "Little Book", Greenblatt wanted to write a book his children could read and learn from. The main point Greenblatt makes is that investors should buy good companies at bargain prices.

Magic Formula Investing uses return on capital and earnings yield as its inputs. Return on capital is seen as the best determinant of whether a business is a good one or not. Companies that can earn a high ROC over time generally have a special advantage that keeps competition from destroying it (e.g. name recognition, a new product that is hard to duplicate or a unique business model).

Earnings yield is the metric that shows whether a company is cheap or not. Greenblatt says that stock prices of a firm can experience "wild" swings even as the value of the company stays relatively constant giving investors opportunities to buy low and sell high.

Calculation / Definition of the Magic Formula

Define minimum Market Capitalization that meets your liquidity needs. Greenblatt used a market capitalization floor of $50 million, but advised that you can set the minimum as high as $5 billion.

Sector Filter: Due to their unique financial structures, all stocks in the financial and utility sectors are excluded.

EY Rank: Rank the stocks in descending order based on Earnings Yield and assign a rank number to each.

ROC Rank: Rank the same stocks in descending order based on Return on Capital and assign a rank number to each.

Add the rankings and select stocks that have the lowest combined ranking score. So a company that is ranked 358nd best in terms of ROC and 122rd highest in EY would gets a better combined ranking (i.e. 470) than a company that is ranked 1st in ROIC but only 950th best in EY (i.e. 951).

As noted elsewhere, one of the advantages of the MFI's relative approach is that the system never runs out of investment candidates. Several value investment strategies have become de facto obsolete over time. For example, whereas Ben Graham successfully searched for so-called "net nets" more than a half-century ago, such companies have become virtually extinct today. By contrast, MFI simply ranks public companies relative to each other. There is no absolute cheapness requirement.

Portfolio Construction

Once the ranking has been developmed, Greenblatt suggests constructing a 20- to 30-stock portfolio by selecting five to seven stocks every two to three months over a 12-month period. He suggests that each stock should be sold after one year, repeating the steps to reinvest the proceeds of securities sold. This approach should be continued over a long-term (3-5+ year) period. In taxable accounts, he suggests paying attention to aftertax returns and timing the sales accordingly.

Geek Stuff

Here are the key definitions - in general, trailing twelve month numbers from the income statement are used or the latest quarterly numbers for balance sheet figures.

Net Working Capital = Max(Total Current Assets - Excess cash - Non-interest Bearing Payables,0). A maximum function is used as Joel Greenblatt has hinted that he uses zero when net working capital is negative.

Non-interest bearing payables = Total Current Liability - Interest Bearing Payables (i.e., short-term debt). This is one way to estimate NIBP via deduction, unless it is directly available.

Excess Cash = Max(Total Cash - LTM Sales * 5%, 0). Excess cash is a matter of debate, since Joel Greenblatt has not answered any questions regarding how this is calculated. The cash to sales ratio seems to be the most common measurement of "needed" cash, with the ratio typically in the 3% to 10% of sales, hence 5% is used as a blended average. Another approach advocated here is Excess Cash = Total Cash - MAX(0; (Current Liabilities - Current Assets + Total Cash))

Does Magic Formula Investing work?

Greenblatt claims in his book that the Magic Formula has averaged a 17-year annual return of 30.8% and beats the Samp;P 500 96% of the time. However, this is a theoretical average, based on purchasing all stocks that show up on the screen every day for 17 years. In practice investors do not do this, rather accumulating 2-3 positions per month over a 12-month period. You can see further theoretical returns on Formula Investing.com. On a more practical level, reliable data on Greenblatt's complete track record is not available. However, from 1985-1994, Greenblatt managed the Gotham Partners hedge fund, reporting annualized returns of over 40% (after expenses, before performance fees).

Watch Out For

The list of candidates generated by the MFI screen is likely to make an investor's stomach churn. Many companies are either in out-of-favor industries or have major company-specific issues. While many investors recognise theoretically that buying good companies when they are out of favor is a path to long-term outperformance, a much smaller number would actually be willing to follow such a strategy. In the book, Greenblatt make clear that the strategy is not a "magic bullet" that always works. During the 1988-2004 period studied by Greenblatt, MFI handily outperformed the Samp;P 500, yet the strategy experienced two non-overlapping three-year periods of underperformance. Sticking to a strategy that is not working in the short run even if it has a good long-term record can be difficult, Greenblatt says, but he believes that you will be better off doing just that than following the latest fad.

From the Source

Magic Formula Investing is described in depth in Greenblatt's quot;The Little Book That Beats the Market quot;. There is also the official site which includes a screener for the US market based on minimum market capitalization (any number between $50 million and $5 billion). Joel Greenblatt has partnered with another investment manager to offer FormulaTrading.com, a managed account for those who wish to implement the "Magic Formula" but do not want to manage on their own.